Should Malawi Have Devalued the Kwacha?

Malawi Kwacha currency

On May 27, 2022, Malawi woke up to the shock that the monetary authorities had devalued the exchange rate by a whopping 25%. The reason given for the devaluation was that we had to align our exchange rate to reflect the value of the kwacha vis-à-vis demand and supply dynamics at that time.

One year down the line, it is nerve-racking and extremely sad to hear that there are fresh calls and sentiments for another round of devaluation. To understand that argument, a bit of theoretical background will serve justice at this point.

A devaluation, by definition, is the official downward adjustment in the value of a domestic currency relative to foreign currencies. In theory, a devaluation is supposed to make foreign goods and services more expensive to import while making our domestically produced goods cheaper to import for foreign buyers. When these two forces combine, again in theory, they are supposed to dissuade imports on one hand and encourage exports on the other hand, thereby improving our foreign exchange position.

Let’s consider this example: Suppose the Kwacha-dollar exchange rate is at K100/$, and you import 1kg of salt at $1 from Botswana and export 1kg of groundnuts at K100 to South Africa. Now, suppose the exchange rate is devalued by 25%. With the devaluation, you now buy the same 1kg of salt at K125 instead of K100. At the same time, those who buy our groundnuts from South Africa will now be able to buy 1.25kg of groundnuts with the same $1. The effect is that since the price of salt has gone up from K100 to K125, the level of salt imports will decline, and by implication, the demand for forex locally will go down.

At the same time, since with the same $1, groundnut importers from South Africa are able to buy more (remember the importing price has decreased, purchasing power-wise), the supply of forex will increase. All this will result in an improved foreign exchange position. It was primarily on this basis that the exchange rate was devalued.

The other argument put forth was that when the currency is devalued, economic agents who would have been holding foreign exchange will now be enticed to sell it to profit from the devaluation, further improving the foreign exchange position.

A devaluation is only as good as I have described; at least, only in theory. In practice, in net-importing economies like Malawi, it only does more harm than good. This is why, a year after the currency was devalued, we are left with less than one month’s worth of import cover, and yet we are in the tobacco marketing season.

Devaluing a currency in a net-importing economy like Malawi only increases the cost of imported goods, leading to higher inflation levels. As imports become more expensive due to a devalued currency, the local population’s purchasing power decreases, leading to a rapid increase in poverty levels, compromising the living standards of the local population. At least, this is what we are experiencing right now in Malawi; the forex situation has actually worsened, and the cost of living has tripled since then.

When considering such macroeconomic policies, critical questions need to be asked first: If we say we want to devalue to align our currency, what comes next? If we say we want to devalue to make exports competitive, which exports are we referring to? To what extent are we looking at the value of these exports? Do these exports have a proper and sustainable production base? If we say we want to devalue to entice hoarders of forex to offload their positions, is data for such readily available? Can we quantify the availability of such foreign exchange with certainty?

A meaningful and effectual devaluation has to be anchored by a strong production base; without it, a devaluation is always catastrophic. This is because without such an anchor, a currency will be devalued at every instance of currency misalignment, which creates a vicious circle of serious macroeconomic imbalances.

Interestingly, Bretton Woods Institutions are not unaware of the deleterious effects of currency devaluation. For instance, the World Bank’s report titled “The Road to Recovery,” released in 1998, alludes to the fact that many of the financial challenges of developing countries are attributed to currency devaluation.

In conclusion, devaluation is a complicated macroeconomic policy that can have a detrimental effect on developing net-importing economies like Malawi. It, therefore, becomes very pertinent for policymakers to understand the potential consequences of devaluation, at least in the most practical sense, including its impact on the government, businesses, and citizens.